Savings

To Boost Retirement Savings, Stop Giving Tax Breaks on 401(k)s

Americans aren’t saving enough for retirement, especially the aging baby-boom generation. It’s a message we hear over and over, and the data are disconcerting. The Federal Reserve’s 2010 Survey of Consumer Finances puts the median balance in 401(k)s/IRAs for households nearing retirement at $120,000. The Employee Benefit Research Institute (EBRI) notes that 60 percent of workers 55 and older have less than $100,000 set aside for retirement. Blue chip consulting firm McKinsey calculates that two-thirds of boomers don’t have enough savings to maintain their pre-retirement standard of living once they’ve waved goodbye to their colleagues for the last time.

Numbers like these help illuminate why the Obama administration’s proposal to cap retirement savings in 401(k)s, IRAs, and similar tax-sheltered accounts isn’t going over well. The cap would also apply to traditional defined benefit pension plans as well. “As business owners reach the cap, they will lose their incentive to maintain a plan, and either shut it down or greatly reduce benefits,” responded Brian Graff, chief executive officer of the American Society of Pension Professionals and Actuaries, in a statement. The Wall Street Journal editorial page scoffed at the cap with this headline: “Now He’s After Your 401(k).” At a hearing, Senator Ben Cardin (D-Md.) questioned U.S. Treasury Secretary Jacob Lew whether the contribution limit would “make it more difficult for people to put money away for retirement.”

Briefly, the administration proposes in its 2014 budget to raise $9 billion by preventing individuals from accumulating more than $3 million in tax-sheltered retirement savings. The $3 million isn’t a hard dollar figure, however. The actual limit is defined by the amount of money that would finance an annuity of $205,000 a year in retirement (about $3 million currently) starting at age 62. EBRI estimates (PDF) that at the end of 2011, taking into account combined IRA and 401(k) balances for individuals age 60 or older in its database, 0.107 percent of these individuals had balances totaling $3 million and above. Of course, people with such large sums could continue to save. They just wouldn’t be able to use pretax dollars.

At first glance, considering the real problem with retirement savings is that most workers haven’t stashed anywhere near enough for old age, the proposal seems to be much ado about nothing (or at least very little). On reflection, the flaws in the idea are glaring. For one thing, the retirement savings cap adds yet one more layer of complexity to a tax code already riddled with too many income and wealth phase-ins and phaseouts, deductions, and credits. For another, $9 billion is a piddling amount of money considering the size of the federal deficit and debt.

How about this idea instead: Repeal the tax break associated with 401(k)s, IRAs, and similar tax-sheltered plans. Substitute automatic enrollment for the subsidies. Eliminating the subsidy would boost the government’s budget by some $100 billion a year. Daniel Shaviro, a professor of taxation at New York University Law School, laid out the logic in a blog post and subsequent conversation:

“First, making pension contributions the default setting, and thus requiring employees to opt out if they’d rather get cash today, has much bigger behavioral effects than giving tax benefits to retirement setting. Second, this makes both them and everyone else better off. Third, we could change the default, repeal the tax benefits for pension contributions, and get more retirement saving while also saving $100 billion per year, from the budgetary effects of repealing the tax benefits.”

Recent economic research strongly supports the policy shift. The main beneficiary of the different approach would be average workers. Take the suggestive insights from the research brief Subsidies vs. Nudges: Which Policies Increase Savings the Most? A handful of American and Danish scholars tapped into rich Danish databases to weigh the relative effectiveness of subsidies vs. automatic enrollment (PDF). (Among the American scholars was Raj Chetty, an economist at Harvard University, who was recently awarded the 2013 John Bates Clark Medal, second only to the Nobel prize.) They tracked the wealth and savings of more than 4 million individuals from 1994 to 2009. Among their findings: People who respond to subsidies—tax incentives—are already active savers. They’re the sort that rationally plan for old age. They tend to be better off. Automatic enrollment boosts the participation of “passive savers,” everyday workers who find it hard to set money aside for three decades from now. The evidence suggests passive savers with automatic enrollment reduce consumption rather than preserve their spending power by borrowing more.

Compared with tax subsidies, the scholars conclude, “automatic enrollment or default policies could increase household savings much more, at a lower cost to the government, because defaults are far more effective at increasing the savings of passive savers.” With time, the Fed, EBRI, McKinsey, and others would report far healthier retirement savings accounts for the median and average employee. And maybe everyone could relax a bit about the retirement prospects of an aging population.

Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.